In his recent paper Kähkönen (1987) shows, with the help of a parsimonious intertemporal framework, that liberalization programs can produce unexpected results. In particular, following the standard recommendation of raising artificially low deposit rates in a financially repressed economy may reduce welfare. Kähkönen notices, however, that his results may be sensitive to the assumption that there is no capital flight. This is a potentially serious drawback because of the empirical importance of capital flight (Cuddington (1986)), but Kähkönen’s results do not seem to depend critically on this exclusion. In this note I indicate how Kähkönen’s model can be extended to incorporate capital flight (see Haaparanta (1987) for a more thorough treatment). It turns out that, although most of the results derived by Kähkönen hold in this extended framework, capital flight reduces the likelihood of welfare losses resulting from higher deposit rates.

The model is exactly the same as in Kähkönen except that, besides saving in the domestic bank (s_D), the individual can illegally invest abroad an amount s_F to earn the return r* with probability Φ (if not caught); if she is caught she loses both the value of investment and the interest on it. The individual determines the allocation of savings to maximize welfare. This is presented by risk-neutral “ordinal certainty equivalent” preferences introduced by Selden (1978). For any levels of savings, the indirect utility is (with Kähkönen’s notation)

where

and

and where y^j is the value of period-j income, π^j the period-j consumer price index, and thus z^j is the period-j aggregate real consumption, with j = 1,2. The function σ describes the gross costs associated with foreign investment; obviously σ(sF) > s_f, σ’ > 1, and σ" > 0, (see Khan and Ul Haque (1985) for a similar treatment when analyzing capital flight). The first-order conditions for the choices of s_D and s_F are

and

which give

For capital flight to occur, it must be the case that $\mathrm{\Phi }(1+r^{*})>(1+r_D),$

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with $S_F^{\prime }$

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where

and

with

R^j is the value of period-j production, and i is the investment in physical capital. Savings in domestic banks can be solved from equation (1), and then welfare from equation (2).

A central theme in Kähkönen’s paper is that liberalization of domestic financial markets and trade are intimately related. Here the impact on welfare of an increase in r_D is

From equation (1) it can be shown that

Consider first the case where t = 0 (that is, A = 1). Equation (3) implies now that welfare increases unambiguously with the domestic deposit rate. Hence the reduction in financial repression is beneficial, eve with capital flight, if trade has been liberalized. But if some tariffs remain, the analysis changes. In Kähkönen’s paper the condition $(1+r_D)/A>(1+r^{*})$

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Thus, with capital flight the welfare may improve even when Kähkönen’s analysis would suggest welfare reduction. Intuitively, the reduction in capital flight tends to increase total savings, which are below the social optimum because of financial repression. Kähkönen’s other major result—that reducing the rate of interest on bank loans toward the world market levels improves welfare regardless of tariffs and financial repression—holds also when capital flight takes place. But if liberalization of capital movements means the reduction in control of foreign investment by households (that is, an increase in Φ), this does not hold (see Haaparanta (1987)) for the same reason that financial repression and tariffs are related. Furthermore, the claim that domestic financial markets have to be liberalized before capital movements are liberalized holds for the case of liberalizing foreign investment by households.